The capital asset pricing
model may be the standard-bearer today, but no one regards
it as the final word in finance. Some day a new model
will probably come along that works better. It may be
a new twist on the basic CAPM, or it may be something
Most of the theories that are used today are some
iteration or extension of the CAPM. However, in 1976
MIT Professor Stephen Ross proposed a new model that
bears no family resemblance. What follows is a brief
sketch of the basic theory.
For full detail, it would be worth reading Ross’s
pioneering article, “The Arbitrage Theory of Capital
Asset Pricing,” Journal of Economic Theory
13: 341-60 (December 1976) (JET prior to 1993
is only available in print through the Z. Smith Reynolds/Chatham
The CAPM, despite its flaws,
has led economists to wonder whether the relationship
between risk and return is captured by other measures
of risk, besides ß. Perhaps there are risks besides
volatility, which is all that ß measures. Perhaps
other proxies (such as company size) can be used to
measure risk. For example, studies indicate that larger
companies have higher returns than smaller companies
with the same price volatility. See Barr Rosenberg,
Kenneth Reid & Ronald Lanstein, Persuasive Evidence
of Market Inefficiency, J. Portfolio Mgmt. 9 (Spr.
1985) (finding ratio of equity's book value to market
price correlated to average returns for U.S. stocks).
Size may be a surrogate for greater liquidity -- and
investors will pay to reduce this risk factor.
From this insight, economists have constructed an
Arbitrage Pricing Theory that relates multiple risk
factors to determine expected returns. Under this model,
an asset's expected return is calculated according to
its sensitivity to each risk factor. For example, a
portfolio's returns might be seen as depending both
on systematic risk and liquidity. APT predicts that
the market capital line will actually be a two-dimensional
plane in which various combinations of risk and liquidity
produce different returns. (For models with multiple
risk factors, returns can be derived from a multi-dimensional
APT assumes, like CAPM, that as an asset's price departs
from the capital market plane, investors will engage
in arbitrage transactions (buy low, sell high) until
the asset's price is pushed back towards the plane.
So, you ask, which risk factors determine the capital
market hyperplane? Well, the APT is currently agnostic.
Maybe future research will show which risk factors matter,
and how much they influence expected returns. At least
four measurable factors seem relevant:
- level of industrial activity (economic risk)
- spread between short- and long-term interest rates
- the spread between the yields of low- and high-risk
corporate bonds (default risk)
- bid-ask spread (liquidity risk).